Those in the energy sector should note that the Administration and Congressional Republicans released a tax reform framework on September 27, 2017, (the "Unified Framework for Fixing Our Broken Tax Code" (the Framework)) designed to simplify the US federal income tax code and lower tax rates. The Framework represents five months' worth of collaboration amongst the so-called Big 6 and is consistent with the themes found in the Joint Statement on Tax Reform that the Big 6 released two months ago. While the Framework lacks specifics, it does outline a way forward for tax reform, encouraging budget committees to pass a budget resolution, and allowing tax-writing committees to determine the details. If ultimately enacted, comprehensive tax reform will have a major impact on the US economy as a whole, and there are specific concerns for the energy sector.

Major tax reform measures

The Framework envisions a reduction of tax rates, with a proposed corporate tax rate of 20% (25% for flow-through entities), a shift to a territorial system of taxation, and the elimination of the corporate Alternative Minimum Tax (AMT), among other items. The Framework also states that committees may consider methods to reduce the double taxation of corporate earnings. Reducing the double taxation of corporate earnings appears to refer to Senate Finance Committee Chairman Orrin Hatch's (R-UT) interest in wholly or partially integrating the corporate and shareholder levels of tax, resulting in a single level of tax on corporate earnings.

To achieve the lower rates, many tax credits and deductions would have to be limited or eliminated. The Framework would limit the deduction for C corporations' net interest expense. Moreover, as another offset for the new, lower tax rates, the Framework would repeal the Section 199 domestic production deduction.

The Framework only mentions retaining two business credits, the research credit and the low-income housing credit. The Framework notes that those credits have been effective in promoting policy goals as intended, and ought to be retained; the fate of other credits, however, remains unclear and will be determined by the tax-writing committees.

Regarding capital expenditures, the Framework also calls for immediate expensing for new investments in depreciable assets, excluding structures, for at least five years. Interestingly, the Framework specifies that full expensing would begin for assets purchased after September 27, 2017, the date of the Framework's release. Further, the Framework acknowledges the existence of special tax provisions governing the US federal income tax treatment of certain industries and sectors and states a goal of modernizing these rules to ensure that the tax code reflects economic reality.

Internationally, the Framework would transition to a territorial system, allowing a 100% exemption for dividends from foreign subsidiaries (in which the US parent owns at least a 10% stake). This would include treating accumulated foreign earnings as repatriated and subject to a mandatory tax to be paid "over several years." The stated goals are to "prevent companies from shifting profits to tax havens" and to "level the playing field between [US]-headquartered parent companies and foreign-headquartered parent companies."

Additional details on the Framework may be found in Tax Alert 2017-1563. The Framework is intended to be a guide for both the House Ways and Means Committee and Senate Finance Committee as they craft specific tax reform legislation. Actual bill language and the timing of a bill will emerge as negotiations regarding tax reform, the budget and other legislative items progress. Statements by members of both chambers indicate optimism that tax reform will be enacted into law.

Implications

It is clear that, if enacted, the proposals described in the Framework could have important and long-lasting implications for the energy sector; effects, however, will vary across mining and metals, oil and gas, and power and utilities (as well as renewables).

Mining and metals

The Framework is a mixed bag of positive and negative news for the mining and metals industry. Although lower stated rates and simplification are generally welcome, the elimination of preferential deductions would alter the effective tax rate for many companies. The percentage depletion, while not explicitly mentioned, could be eliminated. The loss of the ability to claim percentage depletion would be a significant effective tax rate item for many companies, but the combination of this with lower corporate rates may not significantly impact the cash tax liability for many sector companies.

The elimination of the corporate AMT would be a significant simplification for the industry, as many of the preferential deductions, such as percentage depletion, are already substantially added back for AMT purposes. Unlike the 2014 Camp proposal, however, the Framework offers no transitional relief on carryover minimum tax credits, so they may expire worthless. This would be significant for many companies with large minimum tax credits balances that have accumulated over the years. Finally, while retention of the research credit and full expensing for five years are welcome changes, the limitation on interest deductions would significantly affect this very capital-intensive industry.

Oil and gas

The Framework may be positively received by certain oil and gas companies with respect to lower rates, overall simplification and the capital expensing provisions; further details are needed for companies to appropriately evaluate the Framework's overall effects. For example, while the concept of immediate expensing of new investments in certain depreciable assets for at least five years may be beneficial, the oil and gas industry will be focused on what happens after the five-year period so that long-range planning can be effected in a reasonably accurate manner. Similarly, the elimination of the corporate AMT could be a positive change for the industry; however, it will be important to evaluate any potential transition rules, especially regarding the ability to use existing AMT credits that the taxpayer may have at the time the transition would occur.

The Framework is silent on what tax reform could mean to the ability of oil and gas companies to deduct intangible drilling and development costs (IDCs). Under current law, an independent producer may deduct 100% of IDCs in the year those costs are paid or incurred, whereas an integrated oil company may deduct 70% of IDCs in the year it incurs the cost and must amortize the remaining 30% over 60 months, beginning with the month in which those costs are paid or incurred. An elimination of the ability for oil and gas companies to deduct a meaningful amount of IDCs (if such provisions are not retained in final tax reform provisions) could affect the discounted cash flow and the rate of return on oil and gas wells.

Finally, as noted earlier, the percentage depletion for oil and gas investments made by independent producers and royalty owners could be eliminated. While a loss of the ability to claim percentage depletion would be a significant effective tax rate item for independent producers and royalty owners, the combination of this with lower tax rates may not significantly alter the cash tax liability for many integrated oil and gas companies.

Power and utilities

Since regulated utilities are among the most capital-intensive businesses, the Framework could have a material impact on their operations, financial condition and liquidity. US federal tax allowances and accumulated deferred income tax (ADIT) balances are major rate-making components affecting the revenue requirement and allowed rate of return. Lowering the corporate statutory tax rate from 35% to 20% would likely result in regulators requiring utilities to refund customers the resulting excess ADIT, generally over the life of the utility property, with a portion refunded over an agreed-upon period with the utility commission.

As expected, the Framework would limit the current deduction for net interest expense incurred by corporations. It doesn't outline specifics of how a limitation would work in practice, but does acknowledge that certain industries and sectors have special tax regimes that it aims to modernize so that rules better reflect economic reality. To that end, the utility industry has worked closely with Congress and tax writers over the last several months to outline the necessity for preserving the interest deduction for the sector, laying out the effects that a limitation would have on both customers and shareholders. Several key lawmakers have championed the sector's interests in the tax reform debate, and utilities hope that any transition language on interest deductibility would address their issues.

Although the Framework provides for up to five years of immediate expensing, it does not explicitly discuss what happens beyond that time. Due to the capital-intensive nature of the industry, bonus depreciation in recent years has contributed to rate-base disruption and significant US federal net operating loss (NOL) positions for many companies. Even a limited period of full expensing will likely exacerbate the NOL positions of many utilities.

Elimination of the Section 199 deduction would affect generation companies, creating a greater base upon which the reduced corporate tax would apply, for those not in a current taxable loss or NOL position.

Renewables and certain other energy credits

The Framework is silent on whether the wind production tax credit (PTC) or the solar investment tax credit (ITC) (or other related provisions) would be retained. Many industry representatives regard the PTC and ITC as part of the 2015 "deal" that included both the Path Act tax provisions and the oil export authority. The industry trade associations are not, however, taking it for granted.

As for the electricity and liquid renewable fuels energy tax credits that expired in 2016 (certain credits related to biomass, hydro, biofuels, and certain other investments), the more momentum tax reform has, the less likely there will be a separate "extenders" bill in December. Regardless of the tax vehicle, the sector has hope for "transition rules" similar to those received by wind and solar in 2015.

Conclusion

Despite its limited detail on specific provisions, the Framework should not be dismissed. The lack of specificity most likely reflects a desire to maintain flexibility for tax-writing committees and future negotiations rather than a lack of analysis. Given that tax-writing committees have been working on specific legislation since at least since late July (based on the Joint Statement on Tax Reform) and the amount of prior relevant legislative proposals from which to draw, taxpayers should not be surprised if legislation is drafted quickly.

The reduced corporate tax rate and 100% expensing for five years, combined with the shift to territoriality, would be positives for many taxpayers. Further restrictions on net interest expense and the likely elimination of many other deductions and credits, however, are tough to judge at this point. More detail is needed on the rules that the committees intend to incorporate in the tax reform package to level the playing field between US-parented corporations and foreign-parented corporations.

As demonstrated by the prior examples, tax reform would significantly affect the economics of a taxpayer in the energy sector. By combining what we see in the Framework with language from previous seminal tax reform proposals (e.g. the Camp proposal), it is already possible to model the possible effects of many of these tax law changes. The sooner company leadership can get its arms around the prospective effects of tax reform, the better it can communicate with Capitol Hill, and engage in tax-planning as necessary to maximize impending benefits and minimize vulnerabilities.

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